Treating S Corporation Stock Purchases as Asset Purchases

Question:  I am the owner of an S corporation which is purchasing another business operated by an S corporation. I have been advised that I am better off for both tax and liability reasons structuring the transaction as a purchase of the assets of the target corporation rather than a purchase of the stock of the target corporation. However, the target corporation has some licenses and other assets which are not readily transferable making it more beneficial to acquire the target corporation’s stock. Are there any options available to me to avoid the consequences of a stock purchase

Answer:  In the merger and acquisition world, business purchasers generally seek to acquire the assets of a selling corporation rather than the shares of the corporation itself.  Acquiring assets can protect business purchasers from known and unknown liabilities of the selling corporation.  Asset acquisitions also generally offer tax advantages to purchasers in the form of a higher basis in the assets acquired for income tax purposes. Regretfully, many businesses operating in heavily regulated industries have licenses, permits and other assets which prevent asset acquisitions from being a viable option. 

One useful strategy involves an S corporation purchasing the stock of a target S corporation and treating the transaction as an asset acquisition for tax purposes.  S corporations generally pay no tax on their income and the S corporation shareholders report the income of the corporation directly on the shareholders’ personal income tax returns. An election can be made to treat the acquisition as an asset acquisition for income tax purposes.

In this case, both the purchasing corporation and the target corporation are treated as if the purchaser acquired the assets of the target.  If, as is often the case, the fair market value of the assets acquired exceeds the target’s basis in these assets, the purchasing corporation benefits as the higher tax basis will result in higher depreciation and other tax deductions and lower taxes for the purchasing corporation.  The selling shareholders of the S corporation target are treated as if they sold the assets of the target and are taxed accordingly.  Most importantly, for non-tax purposes, the transaction is treated as a conventional stock purchase so that licenses, permits and other difficult to transfer assets remain titled in the target corporation which becomes owned and controlled by the purchasing corporation.

To be eligible to treat an S corporation stock acquisition as an asset purchase, the purchasing corporation must acquire at least 80% of the value and voting rights of the stock of the target corporation within a twelve month period.  Following the acquisition, the parties must file an election with the IRS to treat the stock purchase as an asset purchase.  As in other asset acquisitions, it is customary for the purchaser and seller to agree on the allocation of the purchase price among the assets acquired.  Following the acquisition, the purchasing  S corporation can elect to treat the target as a disregarded entity for income tax purposes and thereby continue to enjoy the benefits of S corporation status.

From a liability perspective, the concern remains that the business of the target corporation will remain subject to the claims of the target corporation creditors, both known and unknown. Nevertheless, many transactions are structured as stock purchases. Careful drafting of the purchase and sale agreement and the use of appropriate protections in the agreement such as indemnities, holdbacks of the purchase price and letters of credit where feasible can address this concern.

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.

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